this is a long and somewhat rambling meditation on some of the issues raised recently. if you bother to read it and have any reactions, thoughts or criticisms, i would be grateful to hear them.
we're certainly in the early stages of another deflation scare [as ej hates to call it]. we're also entering another wave of foreclosures, which should trigger another downleg in housing.
the congress won't extend unemployment benefits but it looks like the bush tax cuts will be extended for all, including the wealthy however defined. [the republicans are willing to play chicken, saying it's all or nothing on extensions, and the democrats are scared of being responsible for an across-the-board tax increase right now, so the whole bush package will be extended. and when there are even more republicans, many tea colored, in the next congress, there will be no tax increases.]
thus we continue to bifurcate the economy, hiving off another wave of losers as u.s. income distribution looks more and more south american. and the trillion dollar deficits extend as far as the eye can see.
i don't think we'll have another financial sector/bank crisis- been there, done that, and everyone now knows where the lines are drawn. the tbtf banks will be propped up no matter what else happens. [anyone recall the movie, "weekend at bernies"?]
where's the bubble? in the '90s it was clear that the tech sector in general, and the internet sector and the "dot bombs" in particular were crazily priced. tech ipo's doubled and tripled on their opening day of trading. people got rich day trading. by the mid '00s it was crystal clear that there was a housing bubble, as real estate appraisers started a petition to ask for federal investigations of the overblown appraisals they were being pressured to produce, and more and more stories circulated about $25k/year gardeners getting 105% ltv mortgage packages on $700k homes. people got rich flipping condos.
so where's the new or the next bubble? i'm not running across news stories about ordinary people getting rich playing some financial game. day trading and condo flippng are equally out of date, and there is no obvious replacement for the speculator in the street. but banksters are getting rich on big bonuses based on trading profits, federal subsidies and extend-and-pretend accounting tricks. one could argue that banksters have been getting rich all along, through all the prior bubbles, so what's new? but i don't see evidence of anyone else getting rich lately.
i think the latest and current distortion is in the sovereign bond market. no surprise there. in place of the gardener who "bought" the big house, we have greece now "stabilizing" with the balm of the ecb's shock and awe trillion dollar rescue package, which is, unfortunately, merely an illusion. the market has calmed, and turned its limited attention span elsewhere for the moment. financially, iceland died, [its last request was that its ashes be spread over europe]. the baltics along with the rest of eastern europe are in deep trouble. i am sure that greece and the other piigs will return to the headlines; the sequel is being written. but the big star of the sovereign debt follies has yet to take the stage. it's uncle sam.
what is the basis of low rates at the long end? i am assuming, for now, that the fed is not already controlling those rates by buying long bonds. it's partly the "flight to safety," or what bill fleckenstein likes to call the flight to quantity. and it's partly a belief that we have very low inflation or even deflationary times as a result of persistent and severe economic weakness. thus the high deficits don't worry bond buyers, since inflation is not nigh. so bond holders, as opposed to traders, are betting on another 10 to 30 years of economic weakness.
but how can the u.s. carry a debt that is growing by about 10% per year? you can say that the interest payments aren't large because rates are so low, but rates are so low because of economic weakness, and that implies anemic tax receipts and even more deficits. so this line of reasoning depends on any inflationary process being far enough away that it doesn't affect this year's investment earnings, or this year's bonus for investment managers. as long as there are no signs of growth in the immediate future, the reasoning goes, bonds will do ok, and the deficit will compound at a 10% rate while tax receipts grow at no more than 2-3%. how long can that go on? longer than someone who is short bonds can remain solvent, i know, but not indefinitely.
why did greece suddenly rocket into the headlines? a new government came in and admitted that the old official figures had been fudged. that forced the financial world to take notice of what had been true, obvious in plain sight to anyone who cared to look, but ignored for many years.
some event will eventually focus the financial world on the contradictions in the u.s. gov't's financial situation. extend and pretend can work for banks if they have enough time and profits enough to accumulate over time, to earn their way out of their hole. but extend and pretend won't work for the federal debt because, although it's in a hole, the federal gov't won't stop digging. at some point the compounding and the ratios becomes manifestly ridiculous. unless we have some significant inflation to discount the nominal debt to something more manageable in real terms.
so what does a bond or funding crisis, or a currency crisis look like for the issuer of the global reserve currency? anyone? bueller? anyone?
a failed bond auction? the cover ratio might go down, but before a failed auction occurs i think the fed would lean on the primary dealers to step up to the plate, the fed promising to quietly take any unwanted paper off their books in the secondary market. the fed might let long rates rise a bit, embarrassed to just nail them where they are now. after all, they want to maintain at least the appearance of propriety if at all possible. they will only nail down the long end at very low levels in the face of notably worse weakness or deflation than we are seeing currently.
a drop in the currency? compared to what? it was strange to see the euro tank because greece could NOT print. surely it is greece et al's INability to print that makes the euro worth holding. i guess the market assumed that the ecb would cave, and cave it has, quietly, subtly. but for all the noisemaking and austerity-swearing in europe, is there any doubt that the ecb is monetizing sovereign bonds? and if germany pushes greece to default, who will rescue the german commercial banks and the landesbanks?
so if the dollar has a "crisis", where will people run? i think that, given the dollar's reserve status, people won't run. they'll walk; they'll quietly edge away; they'll ease out and diversify; but they won't run because there is no market big enough to run away to. the biggest markets are currencies. but there's no currency really worth holding, and the best of the bad lot are all small. the bond market is very big, but bonds are just long duration currency holdings; worse yet. the commodity markets beckon, but they are also relatively small compared to the size of the funds that might want to get away from fiat currencies and bonds. there will be a crazy spike in gold sometime, of course, and maybe in oil as well, but there's too much money sloshing around to fit into the gold market. so there's our source of future inflation: the gradual movement away from paper.
there is a more acute scenario, if- as i suggested at the beginning of this- housing leads the economy on another downleg, and unemployment rises further as layoffs once again start coming faster than people give up looking for new employment, leave the labor force and cease to be counted. [this disappearance of the unemployed is the only thing which is keeping a lid on unemployment now.] so tax receipts drop even more- income taxes, sales taxes, property taxes all drop. the even-more-republican congress won't pony up for the states and municipalities, and the states are still under mandates to balance their budgets, so more state and local employees lose their jobs,and state deficits nonetheless increase in spite of the cutbacks.
a new fiscal stimulus bill is proposed by the obama administration, but it dies on the hill. the annual federal deficit rises anyway, $1.5trillion, $1.7trillion, as tax receipts dwindle and entitlement spending rises, while all the other machinery of government clanks on, lubricated by ongoing appropriations. in a dimly lit office, late at night, in the federal reserve building sits ben bernanke.... determined to avoid a deflationary collapse, the fed launches q.e. ii, doubling the size of its balance sheet from $2.4trillion [which is itself triple where it started 2 years ago], to a neat $5trillion, buying treasuries and munis to support all the domestic government bond markets.
picture yourself at this juncture: where do you want your money? what would you sell? what would you buy? once the fed is buying bonds in size who in his right mind wants to buy them privately? rates will be low, bond prices will be high, but no one but the fed will be buying. stocks? corporate profits are in the tank as the economy plunges. commodities? maybe. economically sensitive goods will go down as consumption drops. dr copper will need emergency care himself. people will want cash. gold will do well. maybe oil.
this scenario is essentially a replay of the last 2 years, but without the stimulus, and with the bailout money going to governments instead of banks. when bailout money went to banks, the banks put the money "to work" not by making loans, but by playing the markets. this rush of liquidity levitated the markets from their lows of march '09. but when the bailout money goes to the federal and state and local governments, it won't move on like a river into the financial markets. it will instead by sprayed around in the myriad ways all these entities spend their money. at the state and local level, bonded projects will get funding in preference to operational costs- schools and bridges will be built, and roads paved, while police forces are cut back and teachers laid off. public goods - toll roads, sanitation plants, water works - will be privatized or placed in public-private-partnerships to try to monetize them for immediate cash availability for operating expenditures of the relevant governmental entity. fees will rise.
we needn't worry what the chinese will do with their currency: they will be earning few dollars as their u.s. export market shrivels. their pace of commodity buying around the world will pick up, if it can. perhaps dr copper will be moved from the icu to less urgent care. the old maid dollars circulating around the world will rise in velocity even as dollars at home slow. foreign dollar holders will buy dollar denominated assets, and as foreigners become less and less eager to accept dollars, those dollars will have to be spent where they are legal tender.